Question

According to the Modigliani-Miller theorem, a firm’s value is independent of its capital structure assuming no taxes or bankruptcy costs. Describe how changing these assumptions (i.e., assume a firm faces taxes with and without bankruptcy costs) influences its choice of capital structure and provide examples of bankruptcy costs.

Answer 1

when we change the basic exemption of this approach that would mean that we are including the tax rates and there are bankruptcy cost also present so when the tax rates are present, the debt capital always have a greater influence as when there is a higher rate of Corporate tax on the debt,that will help the debt capital to gain more advantage because the interest payments on the debt capital are highly Tax deductible so there would be a preference for higher debt capital in the overall capital structure of the company.

Debt capital is highly important when there is a decision regarding a trade off between the cost of financial distress and the advantage which are related to the debt capital due to presence of tax structure which will lead to tax deduction of interest payments recurring to debt holders.

so there should always be a preference for debt holders but it should only be given after adjustment of various opportunity cost and bankruptcy cost associated with it. Equity should be preferred when the company is highly risk averse and the taxes are very low to provide with much of the tax advantage for interest payment.